1031 Exchange FAQs
What is Internal Revenue Code Section 1031?
Since 1921, Federal tax law under Internal Revenue Code (IRC) section 1031 has permitted a taxpayer to exchange business-use or investment assets for other like-kind business use or investment assets without recognizing taxable gain on the sale of the old assets. The taxes, which otherwise would have been due from the sale, are thus deferred. These can range from relatively simple transactions involving commercial, agricultural and rental real estate to more complex transactions involving aircraft, trucks, trailers, containers, railcars, agricultural equipment, other heavy equipment, livestock and other assets. Most 1031 Exchanges involve separate buyers and sellers and are not simple swaps between two parties. Under these circumstances, tax rules require the use of an independent third party Qualified Intermediary (QI). The QI holds the sale proceeds for the benefit of the taxpayer during the exchange, disbursing funds for purchase of like-kind replacement property, and returning any unused funds to the taxpayer at the end of the exchange. 1031 Exchanges must be completed within 180 days. Taxpayers recognize gain and pay tax on any unused funds or when they ultimately “cash out” of their property.
What are 1031 Like-Kind Exchanges?
Like Kind Exchanges, also known as tax-deferred exchanges, are defined by IRC section 1031. Since 1921, section 1031 has permitted a taxpayer to exchange business-use or investment assets for other like-kind business use or investment assets without recognizing taxable gain on the sale of the old assets. The taxes which otherwise would have been due from the sale are thus deferred. Section 1031 transactions range from relatively simple “trade-ins” or 2-party “swaps,” to more complex non-simultaneous 1031 Exchanges involving separate buyers and sellers. Qualifying assets include commercial, agricultural and rental real estate, aircraft, trucks, trailers, containers, rail cars, agricultural equipment, other heavy equipment, livestock and other assets involved in a broad spectrum of industries. Tax rules for non-simultaneous exchanges require the use of an independent third party Qualified Intermediary (QI). The QI holds the sale proceeds for the benefit of the taxpayer during the exchange, disbursing funds for purchase of like-kind replacement property, and returning any unused funds to the taxpayer at the end of the exchange. Section 1031 exchanges must be completed within 180 days. Taxpayers recognize gain and pay tax on any unused funds or when they ultimately “cash out” of their property.
Who uses 1031 Exchanges?
All businesses, manufacturers, real estate investors, companies in the construction, trucking, rail, marine and equipment leasing industries, farmers, ranchers, individuals and more make good use of like-kind exchanges. 1031 Like-Kind Exchanges are one of the few incentives available to and used by taxpayers of all sizes. A recent industry survey showed that 60% of exchanges involve properties worth less than $1 million, and more than a third are worth less than $500,000. Qualified Intermediaries (QI) facilitate non-simultaneous tax-deferred exchanges of investment and business use properties for taxpayers of all sizes, from individuals of modest means to high net worth taxpayers and from small businesses to large entities.
What are the benefits of 1031 Like-Kind Exchanges?
Following a like-kind exchange, the business or investor is left with more working capital and can roll that money back into the business. The economy benefits because the business owner cannot receive a tax deferral benefit without reinvesting those savings back into the business, so businesses are encouraged to expand or upgrade their properties, machinery, equipment and other assets. Since properties located or used within foreign countries are not like-kind to assets in the United States, section 1031 promotes reinvestment and job growth within our US borders.
Does the tax ever go away?
With 1031 Exchanges, taxes are deferred but not eliminated. These legitimate transactions utilize an important tax planning tool. Payment of tax occurs:
- upon sale of the replacement asset;
- incrementally, through increased income tax due to foregone depreciation; or
- by inclusion in a decedent’s taxable estate, at which time the value of the replacement asset could be subject to estate tax at a rate more than double the capital gains tax rate.
What are the tax policies upon which 1031 Exchanges are based?
Section 1031 has remained in the tax code since 1921, notwithstanding repeated Congressional scrutiny, because it is based on sound tax policy that is predicated on continuity of investment by the taxpayer.
- Section 1031 is consistent with goals of efficiency, neutrality, fairness, and simplicity within the tax system.
- Section 1031 promotes business decisions that stimulate US job creation and growth of the US economy.
- Section 1031 promotes efficient use of productive capital and operating cash flow.
- Section 1031 exchanges facilitated by Qualified Intermediaries are neither abusive nor administratively difficult for either the IRS or taxpayers.
- Section 1031 benefits and is widely used by a broad spectrum of taxpayers at all levels, in all lines of business, including individuals, partnerships, limited liability companies, and corporations
Section 1031 and the Economy
How do 1031 Like-Kind Exchanges stimulate the economy?
Like-kind exchanges contribute to the velocity of the economy and promote job growth within the United States. §1031 stimulates the economy, encouraging real estate transactions, and encouraging companies to replace and upgrade machinery and equipment, stimulating purchases and sales of machinery, equipment, railcars, aircraft, trucks and other vehicles sooner, because tax on the gain can be deferred.
Owners of personal property assets used predominantly in the United States may only obtain tax deferral benefits by reinvesting in like-kind domestic assets. An energy company, for example, cannot receive tax deferral benefits for selling mining, gas and oil field machinery in Texas and moving their production activity to Canada. §1031 provides a strong incentive to multinational companies to maintain and increase investments in the US.
Transactional activity results in taxable income, job growth, manufacturing, financial services, construction, improved neighborhoods and tax revenue to states and local communities. Ultimately, this economic stimulus spills over to create jobs in factories, restaurants, recreational, hospitality, tourism and other local small businesses that generate revenue from the after tax dollars of employed workers.
How can 1031 Exchanges benefit businesses, and ranchers and farmers?
For all businesses, section 1031 permits efficient use of productive capital and cash flow while allowing taxpayers to shift to more productive like-kind property, change geographic locations, diversify or consolidate holdings, or otherwise transition to meet changes in business needs or lifestyle. Tax-deferred exchanges provide an important stimulus to a multitude of economic sectors, having local, national and global effect.
Farmers and ranchers use 1031 Exchanges to combine acreage or acquire higher grade land or otherwise improve the quality of the operation. Retiring farmers are able to exchange their most valuable asset, their farm or ranch, for other real estate without diminishing the value of their life savings.
How can like kind exchanges be used for conservation and environmental policies?
Section 1031 is used to promote conservation and environmental policies. Grants of conservation easements can be structured as tax-deferred exchanges, facilitating government and privately funded programs designed to improve water quality, reduce soil erosion, maintain wetlands and sustain critical wildlife habitat. These exchanges also enable landowners to acquire replacement farm or ranchland in less environmentally sensitive locations.
How does depreciation impact exchanges to make section 1031 revenue neutral?
When a depreciated asset is exchanged under section 1031, the taxable gain / depreciation recapture is not recognized, but rather is rolled into the new asset. Depreciation is only allowable for any remaining tax basis and for value representing additional capital investment into a like-kind asset. For example, a company vehicle has a fair market value of $10,000, but it is fully depreciated. It has a tax basis of $0 and depreciation recapture gain of $10,000 at the time of sale. If it was exchanged for a replacement vehicle at a cost of $10,000, that replacement vehicle would have the same tax characteristics and no further depreciation would be allowed. If the replacement vehicle cost $25,000, then only $15,000, representing the additional investment, would be available for additional depreciation over a new tax life. If the relinquished company vehicle was not fully depreciated, but had a remaining tax basis of $2,000, and the new vehicle cost $25,000, then the maximum depreciation allowed on the replacement vehicle would be $17,000 (remaining tax basis plus additional investment).
The total depreciation expense allowed over the life of an asset which participates in an exchange or an ongoing exchange program is no greater than the depreciation expense of an asset that does not participate in an exchange or exchange program. Section 1031 benefits the taxpayer by permitting immediate reinvestment of the entire amount of sale proceeds back into the business, rather than impacting cash flow by forcing that taxpayer to recoup that capital investment slowly, over a multi-year depreciation schedule. Essentially, it provides a cash flow timing benefit.
Over the tax life of a depreciable asset, the dollar impact of section 1031 to the US Treasury is zero.